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General Electric Issues Equity?!

When debt financing is the next best thing to free money, GE dilutes shareholders instead.

On Monday, something happened that for the life of me I cannot figure out. The facts of the matter are simple: General Electric(NYSE:GE) priced 119 million new shares at $31.83, which would yield the company more than $3.8 billion.

I have one question: Why?

Not why did General Electric raise money -- they told us that. It will help pay for a controlling stake in Vivendi's(NYSE:V) U.S. entertainment properties, which coincidentally will cost about $3.8 billion. GE will combine these assets with its existing television properties, which include NBC, CNBC, MSNBC, and Bravo.

Nowadays, you can't drive past the Federal Reserve building with your windows down for fear of being pelted with money. So why did GE elect to use equity instead of debt? GE had the reputation of treating its equity with a level of sanctity -- it's precious. But in a time when the company and its AAA rating could borrow money at rates that are the lowest in postwar history, GE sells its stock instead. I'm really baffled. (For more on the benefits of borrowing, read Brian Graney's excellent overview: Debt Isn't Always Bad.)

You might wonder why this is a big deal. To be perfectly frank, it may not be. But of the various ways to raise funds, equity is generally the most expensive route, and it has the stigma of diluting existing shares. Debt has an interest payment component, but it also provides substantial tax benefits that can be used to reduce current earnings as reported to the IRS.

No such benefit exists with equity, where the proceeds from the offering are simply the share price minus the offering expense. All else being equal, most companies would find debt to be preferable. But as we've discussed, not only are things not equal, but debt for gilt-edged companies like GE is dirt cheap. Banks are willing to roll out the red carpet for a company with GE's credit quality.

Equity comes at a higher cost in most circumstances and equates to permanent dilution. There are situations when a company should issue equity instead of debt. See if any of these fit GE:

Interest rates are high. Nope. GE could issue debt now that would be the next best thing to free money -- plus they'd get tax deductions. This isn't it.

Debt unavailable to company. Any investment banker would eat his or her own desk to be able to write debt to GE. This is one of only of a handful of companies rated AAA, putting it in the league of Merck(NYSE:MRK), AIG(NYSE:AIG), and Berkshire Hathaway(NYSE:BRK.A), among others. GE isn't some post-IPO moonshot looking for more oxygen.

Additional debt might put credit rating at risk. Now we have something that is possible. Including GE Capital, General Electric has more than $195 billion in long-term debt, though this is more than covered by its liquid assets alone. If GE wanted to issue debt, my guess is that its financial team could have figured out a way. The amount of debt at GE has skyrocketed in the past three years, so perhaps the company's coveted rating really would be at risk.

The company thinks stock is expensive.Cisco(NASDAQ:CSCO) intelligently used its overpriced stock for years to buy components. GE could be saying that at $31 its stock is overpriced, and thus makes this option cheaper than debt. One problem: If the stock is overpriced now, what does that say about the $1 billion worth of stock GE bought back in 2002, or the $2.4 billion it repurchased in 2001, at prices that, when blended, are substantially higher than the current one? If it wasn't too expensive to buy back in 2001, it's certainly not too expensive now. This doesn't make sense.

So we can basically eliminate the possibility that this equity is cheaper to GE than debt, unless this straw really would have risked breaking the camel's back from a ratings perspective. This is not a company that makes a habit of issuing more stock, so there is a definite cost of a little bit of security among shareholders. They no longer have the same level of comfort that GE's stock is a limited commodity. So why? Why? Why?!?

Well, after reading the kind things that Warren Buffett had to say this past week about Jeff Immelt's incentive package as GE's CEO, I took the time to look at some of the inputs. Although I don't wish to argue incontrovertibly that Mr. Immelt's paycheck was placed ahead of the company or the shareholders, I can't shake the impression that this move fits quite well in maximizing the inputs for his compensation.

Immelt's 2003 bonus was paid in incentive units, 250,000 of them, all told. If cash flow from operations grows, on average, 10% annually between 2003 and 2007, 125,000 of Immelt's performance share units convert to stock . We're not talking cash flow per share, mind you. Total cash flow. The other half is based on total shareholder return beating or meeting the S&P 500 average over the same period.

Neither of these elements considers the equity account, and neither is helped by the annual debt payments that would lower earnings. So even if the company has to dilute existing shareholder value, from a compensation perspective, this is a preferable way to go.

Do I think that this is what happened? Not really, but I can't help but notice the synergy between this avenue and the compensation at the top. It is axiomatic that managers at every level will focus on the elements upon which they are judged and compensated. Obviously, GE's not going to come out and say one way or the other. And perhaps there's some rational financial element that I'm not considering. But looking at the financial environment, and GE's past moves, I'm still scratching my head over this decision.